Opinion: Global economy and financial markets are saddle sore

SatyajitDas

In late 2015, Mr. Market regained his irrational exuberance. He bounced back from the depressive episode of August 2015, though more on short-covering than on fundamentals. His condition has now suffered a setback, with violent mood swings again in evidence.

Mr. Market’s other supports are also losing strength. Share buybacks, capital returns, unsustainable dividend payouts, and debt financed mega-mergers cannot continue to hold up values forever. So-called Unicorns (start-ups with valuations greater than $1 billion) in technology and biotechnology reflect the desperate search for growth and dangerous optimism about prospects. Valuations, such as transportation provider Uber’s private market valuation of $50+ billion, are not supported by economics but rely on promotion by shrewd principals, venture capitalists, and investment bankers.

With negative yields, investing in government bonds requires ever larger negative rates to provide capital gains. Investors who chased higher returns in corporate- and emerging-market debt face problems. Credit spreads have increased, especially in high-yield bonds. They still do not provide adequate compensation for potential future rises in default rates. Feted earlier as astute investors, holders of debt of frontier countries, such as Ukraine, Zambia, Rwanda and Sri Lanka, now face losses on their investment as booms turn to bust in a familiar cycle.

Real estate prices have risen sharply, driven in some by the sharp falls in the last crisis. Disillusion with other asset classes, cultural biases that favor property and the inexorable flow of capital fleeing unrest or risk has boosted property values, especially in desirable world cities.

Mr. Market’s dysfunction is evident in analyst David Rosenberg’s sardonic observation that today investors purchase bonds for capital gains and shares for income.

Quantitative easing has become quantitative exhaustion

Meanwhile, Mr. Global Economy’s stresses are increasingly being seen in volatile currency values. Countries use a mixture of low interest rates, QE, and direct intervention to manage the exchange rate. This is designed to reduce the value of outstanding debt held by foreigners. It also increases competitiveness and a nation’s share of global exports and growth. Yet Mr. Market’s ability to withstand the fluctuations and pressures of such currency wars is questionable.

A stronger U.S. dollar
DXY, +0.07%
will pressure U.S. corporate earnings and competitiveness, in turn affecting equity values and economic activity. A higher dollar, higher interest rates, and tightening global liquidity conditions represent a major challenge for emerging markets. Capital outflows have weakened emerging market currencies. This has reduced the availability of and increased the cost of finance. Weak export revenues, falling currency reserves, and unhedged U.S. dollar currency, combined with around $9 trillion of debt, will squeeze these economies and drive instability.

Confident in their ability to juggle grenades with their pins pulled out, market analysts are trying to pick bottoms in weak emerging economies. They ignore the fact that the rise in the U.S. dollar may be part of a longer-term trend, paralleling a similar trajectory in the late 1990s that triggered the Asian monetary crisis, Russia’s default, and a plunge in crude oil to $10 a barrel.

Much of the improvement in the condition of both Mr. Global Economy and Mr. Market, especially the latter, is due to the administration of ample amounts of vital liquidity. But the treatment addressed symptoms rather than the disease, and may have reached a point of diminishing returns. More of the same — QE, negative interest rates, additional fiscal stimulus — is increasingly difficult. Quantitative easing has become quantitative exhaustion.

Satyajit Das is a former banker and author whose latest book, The Age of Stagnation, will be published in February.

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